After completing a thorough business review, PepsiCo (PEP) management announced the results of their findings during last week’s Q4 2011 conference call; here are the highlights of the full year numbers, along with the result of management’s portfolio review and the changes shareholder’s should be looking for as we head into 2012:

Full year revenue increased by 15% to $66.5 billion (second largest food and beverage business in the world), driven by an 8% increase in worldwide snack volume (2.5% on an organic basis) and a 5% increase in worldwide beverage volume (1% on an organic basis); reported net income increased 2%, and EPS increased 3% from a year ago to $4.03 per share. Core EPS, which excludes certain items, increased 7% from a year ago to $4.40 in 2011.

THE LAST FIVE YEARS

In the past five years (Indra Nooyi became CEO in late 2006), the company has delivered an increase in core net revenue of 13% per annum, an increase in core operating profit of 9% per annum, and an increase in core EPS of 8% per annum; during that same time period, the company returned more than $30 billion to shareholders, largely driven by a 12% (average) annual increase in dividends per share.

In that same five year period, emerging & developing market revenues have increased from $8 billion to $22 billion, an increase of more than 22% per annum; as a result, this portion of PepsiCo’s business has increased from 22% to 34% of total revenues, and is expected to reach 50% by the end of the decade.

“VALUE IS MAXIMIZED AS ONE COMPANY”

In regards to the chatter over splitting the drinks and snacks businesses, Mrs. Nooyi made it clear that this was not in shareholders’ best interests: “the overriding finding from our portfolio analysis is that PepsiCo's value is maximized as one company.”

Management believes that the key advantages of staying together are in three areas:

Second, it enables us to accelerate in-market growth because in market we benefit from the coincidence of snack and beverage consumption occasions. We benefit from the commonality of consumer and the opportunity to cross-merchandise and promote our products. But in emerging markets, in particular, our Snacks business benefits massively from the scale of our Beverage business, which can be scaled up very quickly. And without the presence of our Beverage businesses, our ability to establish and grow Snacks businesses in emerging markets would be significantly reduced…

The third reason is that, our operation as one company enables us to share capabilities across geographies and sectors and allows us to attract better talent. This is important everywhere in the world, but particularly in emerging and developing markets where the combined scale of our two businesses helps us be the preferred company to work for…”

DOMINANCE IN SNACKS

Speaking of PepsiCo’s snack business, it is consistently overlooked and treated as though it’s secondary to the company’s success by the financial media; here’s a couple of the figures that should make investors reconsider that viewpoint: Lay’s is the #1 global food brand, with a 10x relative market share globally over the next closest competitor.

Since the numbers internationally aren’t separated by business, let’s just look at Frito-Lay North America (FLNA): in 2011, the segment generated $13.3 billion in net revenues (up 6% year over year, and more than 20% of the company total) and $3.6 billion in operating profit (up 7% year over year, and one-third of the total before corporate expense allocation); that’s 10% more in operating profit than the PepsiCo American Beverages business generated for the year, in a market where the company has a near monopoly and continues to replicate their growth strategy across the globe. This dominance explains why one of the key strategic priorities at PepsiCo (and part of the rationale for staying together as one company) is to “leverage the coincidence of consumption between snacks and beverages and capitalize on this cross category presence to grow scale in individual countries”.

KEY CHANGES IN 2012

In regards to the changes that are coming as a result of the portfolio review, they are as follows:

1. Significantly increase investments in PepsiCo’s iconic brands and in bringing innovation to market. As part of this initiative, the company plans to increase A&M spend $500-$600 million in 2012 (increase of 15% year over year), with the majority in North America and on the company’s 12 mega brands: Pepsi, Dew, Sierra Mist, 7Up in international markets, Gatorade, Tropicana, Mirinda, Lay's, Doritos, Cheetos, Lipton, Quaker and Sun Chips. Additionally, incremental investments in routes and display racks will be around $100 million in 2012.

2. Implement a three-year productivity program that is expected to generate over $500 million in incremental cost savings in 2012, further incremental reductions of about $500 million in 2013, and an additional $500 million in 2014. This includes headcount reductions of about 8,700 employees across 30 countries, equal to roughly 3% of the Company’s global workforce.

3. Improve net return on invested capital (ROIC) by at least 50 basis points annually beginning in 2013 through increased focus on capital spending (for example, 10% reduction in 2012 CapEx and a perpetual decrease from 5.5% of sales to roughly 5%) and working capital management (the targeted 10% reduction in the cash conversion cycle could generate $200 million in incremental cash annually); this initiative is centered on improving the efficiency of the existing asset base.

One part that is particularly interesting is the cost component: PepsiCo currently spends 29% of revenues on raw commodities, about 5% on A&M, and the remaining 50% on manufacturing and SG&A, bringing us to the operating profit margin of roughly 16%.

On the commodity side, there isn’t much you can do. With A&M, the company plans to increase that expense from 5.2% in 2011 to 6% of sales by 2015, which has us moving in the wrong direction from a cost perspective. As management pointed out on the call, their plan is to work with the 50% piece, and to take out 250-300 basis points of cost over the next 3-4 years; the plan includes reducing general and administrative expenses by reducing the layers of management and consolidating facilities (headcount reduction, as noted above, is a key part of this transition).

2012 & BEYOND

As a result of the business review, management announced that they are content with their previously voiced long term goals of mid-single digit revenue growth and high-single digit EPS growth. For 2012, management expects core EPS to be down 5% on a constant currency basis to $4.18 per share (and 8% with currency headwinds included); however, this hasn’t impeded their plan for returning cash to shareholders: the board has announced a 4% increase in the dividend to $2.15 per share for 2012 (40th consecutive year of dividend growth), and the company will repurchase “at least” $3 billion in common stock for the year, an increase of roughly 25% (at $3B flat) from 2011.

About the author:

The Science of Hitting

I'm a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves (potentially over a period of years). As this would suggest, I run a fairly concentrated portfolio by most standards, usually with the majority of the value in a handful of names; from the perspective of a businessman, I believe this is more than sufficient diversification.

I hope to own a collection of great businesses; to ever sell one, I demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.

Comments

I don't really understand the management's talk about their key advantages of staying together. I don't see much overlap of beverage and snack in R&D, procurement, consumer insight, and merchandising. So, can you explain me about cross leverage across the value chain?

On the second advantage, is it about the ease of distributing their snacks when they have distribution system of beverages in place?

Finally, do you think the combined scales of the two businesses make PepsiCo a more attractive place to work for?

The biggest items for me is the power in negotiation with retailers, the cross-platform reach to consumers, and distribution. On the first point, look at Coca-Cola, which was pulled from Costco shelves for a bit in 2009 due to a price dispute; large retailers are increasingly powerful in negotations, and having a larger stable of key consumer brands under one roof (Gatorade, Tropicana, Naked, Frito-Lay, Pepsi, etc) is an important barganing chip that tilts the scales that much more.

For consumers, Pepsi has a huge untapped opportunity to cross-promote their brands; while management has consistently talked about this (since at least the 2-day analyst event last year), I've seen/heard of little to date to push this initiative.

In regards to employment, I think that point is a really small piece of the decision; PepsiCo has been consitently ranked a great place to work, and I don't think that's because they sell chips AND soda.

Balajisridharan,

I was referring to the Frito-Lay business; sorry if that didn't come across clear. I say that they have a near monopoly due to their outsized market share (50% plus in most key markets), which is 10:1 over their nearest global competitor. For example, Frito-Lay increased volume by 1% in Q4, compared to a 1.5% decline for the market (according to John Compton, CEO of PepsiCo Americas Foods); at the same time, the division took nearly 5 points of pricing, resulting in revenue growth of 6% for FLNA in Q4 (on a constant currency basis). I could talk further on this if you have other questions...

Extramiler,

Honestly, I'm not concerned with their margins (in the short term); I'm only interested in watching the competitive dynamics of the segments they compete within and making sure they sustain the moats that allow them to generate excess free cash flow.

I think they can take price when needed, particularly in snacks; I'm not concerned about the attractiveness of this business, but rather some of the red flags that pop up in the management team. The stated initiatives will be a key part of Mrs. Nooyi's tenure, and will determine her legacy at PEP.

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